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October 30, 2008

Disintegration of the Big Four -- Where is the Tipping Point Today?

Time for an update: how large is the litigation hit that would devastate one of the Big Four accounting firms?

The answer is a number that is shockingly small, in light of the large firms’ aggregate estimated litigation exposure of up to $140 billion and their individual confrontation of multiple claims ranging up to and well above $10 billion.

But it cannot be avoided. Reckonings are coming, when the debate on the survivability of privately provided audit services is revived – which will be some time after the U.S. elections and the dust-settling around the world’s banking bail-outs.

Quantification of the impact that would trigger the disintegration of the global networks -- leaving the world’s large companies unable to procure the audit reports necessary for listing and regulatory compliance – was a subject last visited two years ago.

A study done in September 2006 for European Union markets commissioner Charlie McCreevy (here) did that calculation for the large U.K. firms. I applied its model to the Big Four’s American firms that December (re-published here) – and attracted no substantive disagreement, but instead grudging if off-the-record concurrence from those positioned to know.

A revision is now possible, and the news is no less grave.

The recent report of the U.S. Treasury’s Advisory Committee on the Audit Profession (here), for all its insipid unwillingness either to acknowledge the gravity of the audit survival risk or to propose an achievable course of action toward real solutions, did provide updated financial data from the large firms.

Those figures can be run through the prior model, after a quick recap of its basic assumptions:

• Not having access to outside investors, under regulatory limitations, and impelled by tax laws to distribute their profits, the accounting firms operate on the thin but vital base of their partners’ personally invested capital.

• The insurance industry’s readiness to contribute to the firms’ litigation outcomes is insignificant compared to the size of pending claims; comes – if at all – only on top of large and growing deductions and retentions; and in any event takes primarily the form of time-shifting finance.

• As a result, large litigation settlements must be funded out of future partner profits, which depend on the ability of the firms to retain both clients and personnel.

The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.

Based on the profits calculable on the Big Four firm’s U.S. revenues of between $5.3 and $9.8 billion, as provided to the Treasury Committee, the bust-up figures would be as small as $560 million, up to just over $2 billion. (Those wanting a walk through the model are invited to write me.)

Could such death-blow amounts be inflicted? On top of the firms’ recent hefty payments to settle many (but not all) of the wave of post-Enron litigations, the outstanding jury verdict of $521 million against the Seidman firm in Florida (see here) starkly demonstrates the possibility. And the obligation of plaintiffs’ lawyers to represent their clients’ antagonistic interests weighs against any lingering unwillingness they would have to kill the gaggle of golden geese.

Would the Big Four firms’ international networks step up? Although by all measures the most cohesive and financially robust of the firms, Arthur Andersen collapsed in 2002 with a speed that suggests otherwise: that firm’s ability to call on either foreign resources or partner commitment proved ephemeral.

Keep in mind that loss of another Big Four firm will throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an untenable business. So the stability of the entire fragile structure includes the continuing survival of the weakest of them.

That in turn exposes the hopeless state of the public debate. When corporate bankruptcies have shot far beyond the $100 billion mark, it’s a dead certainty that investor advocates can kill at birth any proposal to limit auditor liability at a level low enough to include the tipping points.

Nothing less is required, then, to enable the survival of large-company audits under the current model, than a de-coupling of the machinery of investor protection and auditor oversight and enforcement from the Big Four firms’ fragile capital structures.

Until that point is recognized and on the table – even if not agreed—the debate goes nowhere. While the risk of catastrophic failure only grows.

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